Overpriced Winners

Kent Daniel, Ph.D., Columbia Business School and NBER, Alexander Klos, Ph.D., Kiel University and Kiel Institute for the World Economy, Simon Rottke, Ph.D., FCM, University of Munster

2017 HONORABLE MENTION

Kent Daniel, Ph.D., Columbia Business School and NBER, Alexander Klos, Ph.D., Kiel University and Kiel Institute for the World Economy, Simon Rottke, Ph.D., FCM, University of Münster

Overview

Stocks with low institutional ownership which, over a one-year
period leading up to portfolio formation, earn strong positive
returns and experience a simultaneous increase in short interest,
subsequently earn strikingly low returns over the following
five years. The authors argue that the high prices of this set of
“overpriced winners” are a result of excessive optimism by a group
of investors combined with arbitrage constraints for the rational
investors.

Investigation

The authors use data from CRSP, Compustat, and Thomson-Reuters Institutional 13-F filings over a sample period from 1989
to 2014 for U.S. common stocks. The authors first empirically
confirm the literature on momentum — looking at the 20% of stocks with the highest and lowest cumulative returns over the
past twelve months, excluding the most recent month, the past winners outperform the past losers, as expected. However, from
that group of past winner stocks, the authors further identify a “constrained winners” portfolio consisting of those in the bottom
20% in terms of institutional ownership and in the top 20% in terms of their increase in short interest. These last two additional
characteristics suggest these past winners have strong limits to arbitrage. The new finding here is that the constrained winner
portfolio earns a meaningfully negative abnormal return of -2.47% in the first month after portfolio formation. Over the five years
following portfolio formation, the overpriced winners lose a large share of their pre-formation gains relative to the market. Small
and medium-cap momentum strategies, which exploit the fact that an asset’s relative performance tends to continue in the near
future, can be enhanced by avoiding the small subset of overpriced winners.

The authors suggest that excessive optimism comes into play in that the constrained winners have experienced an irrational run
up in price that implies a predictable strong decline, making them “overpriced winners.” Their argument requires an evolution of
beliefs among investors. If institutional lending supply is high, then the price will adhere to the rational expected value and thus
will be fairly priced, on average. However, if borrowing shares is difficult or costly, the views of a group of pessimistic investors
are restricted and therefore cannot be expressed in prices. As disagreement falls over time, however, due to new information
regarding the company’s financial health for example, the price converges to the rational price based on fundamentals.

Finally, the authors find that a “betting against winners” portfolio that buys a broad portfolio of past-winners and shorts a much
smaller portfolio of constrained past winners earns a Sharpe ratio of 1.08 and a significant Fama-French three factor alpha of
2.71% per month over the sample period.

Conclusions

The authors propose a model that captures the effects of limits of arbitrage and excessive optimism or disagreement about the
value of a stock. The results suggest that there is a subset of high past return stocks that earn strong negative post-formation
returns. This small group of “overpriced winner” stocks has low institutional ownership, suggesting short-sale constraints, and has
an increase in short interest consistent with their price increase being driven by increased optimism among a subset of investors.
When new information reveals the true fundamental value, optimism wanes, and the stock price declines towards its fair value.
This dynamic in beliefs among investors is consistent with the notion that short-sale constraints sideline more pessimistic market
opinions, which when coinciding with excessive optimism, can result in temporary overpricing, followed by an eventual correction.
Identifying these constrained or overpriced winners can help enhance a small-cap momentum strategy by either avoiding such
stocks or actively trying to short them.

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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

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